U.K. Pension Funds Add Inflation Hedges on BOE Stimulus Outlook

April 5 (Bloomberg) -- The U.K. pension funds of Royal Bank
of Scotland Group Plc, aerospace components maker GKN Plc and
the London Pensions Fund Authority have bought inflation-linked
bonds and derivatives to limit the impact of salary and price
increases in their defined-benefit obligations.

RBS purchased 2.9 billion pounds ($4.4 billion) of notional
inflation swaps and 1.1 billion pounds of inflation-linked gilts
last year to hedge its 25.6 billion-pound defined-benefit
pension fund, according to its annual report published on March
27. GKN increased holdings of inflation-linked securities and
swaps to 1 billion pounds in 2012, according to a Feb. 26
statement to analysts.

The purchases highlight the demand that may have
contributed to a recent increase in the prices of inflation-linked gilts and derivatives. Attempts by the government and
Bank of England to stimulate the flagging U.K. economy indicate
a higher tolerance for inflation, prompting pension funds to
consider additional hedging to protect returns.

The U.K. 10-year break-even inflation rate, a gauge of
market expectations derived from the yield difference between
regular and index-linked gilts, rose to 3.37 percent on March
14, its highest level since September 2008.

The rate indicates that average U.K. inflation would need
to exceed 3.37 percent per year over the next 10 years for
index-linked bonds to outperform nominal gilts.

Retail Prices

Retail-price inflation, used by the U.K. government to
calculate the returns on index-linked gilts, slowed to 3.2
percent in February from 3.3 percent in January, the Office for
National Statistics said on March 19.

“Following the adoption of a more liability-driven
approach we’ve decided to extend interest rate and inflation
hedging across the entire fund,” Mike Taylor, chief executive
of the 4.5 billion-pound LPFA said in an interview. “Our
immediate priority is to limit inflation risk.”

The LPFA had previously limited hedging to the 1.5 billion
pound part of the fund that paid pensions to existing retirees.
The fund hadn’t yet decided the extent of its additional
hedging, Taylor said.

An increase in U.K. inflation of just 0.25 percent would
add 1.1 billion pounds to RBS’s pension liabilities, according
to its annual report.

Inflation Management

“Swaps are part of the management of the inflation and
interest rate sensitivity of the Main scheme liabilities,” RBS
said in its annual report. “The majority of swaps are with The
Royal Bank of Scotland Plc and National Westminster Bank Plc.”

The investment decisions of the RBS Group Pension Fund are
the responsibility of the RBS Pension Trustee Ltd., Linda
Harper, a spokeswoman for RBS, wrote in an e-mailed statement.

Robert Waugh, chief investment officer of the Trustee
company, declined to comment.

GKN said on Feb. 26 that it hedged 40 percent of the
liabilities of its 2.66 billion-pound pension fund last year.

“Pension actions and de-risking continue to be a key
focus,” GKN’s Chief Financial Officer William Seeger said on a
Feb. 26 earnings call. “In the U.K., we have increased
inflation hedging to around 40 percent of liabilities with
inflation capped at 3 percent.”

GKN said it hedged five-, 10- and 15-year inflation using a
combination of index-linked gilts and swaps. The company used
the Netherlands-based specialist manager Cardano BV to execute
the inflation-swap transactions with a number of dealer banks.

The LPFA currently uses Bank of New York Mellon Corp.’s
subsidiary Insight Investment to manage its derivative hedging,
and was likely to extend Insight’s mandate, Taylor said.